Current issues in economics

Paradox of Thrift – Great Depression & GFC

Although the paradox of thrift has been a regular part of the CIE A Level syllabus it is has only become more relevant since the Global Financial Crisis (GFC). It has its origins in the 1714 book entitled ‘The Fable of Bees’ by Bernard Mandeville but it was John Maynard Keynes who really popularized this concept during the Great Depression of the 1930’s. Classical economic theory suggests that greater levels of saving will increase the amount of loanable funds in the banks and therefore reduce the cost of money – interest rates. This allows people to put off consumption to a later date thereby avoiding the risk of taking on debt and thereby give people security if their jobs became threatened during a recessionary period

Keynes’ beliefs
Keynes argues that saving was not a virtue from a macroeconomic view as he believed that negative or pessimistic expectations during the Depression would dissuade firms from investing. Cutting the rate of interest is supposed to be the escape route from economic recession: boosting the money supply, increasing demand and thus reducing unemployment. He also suggested that sometimes cutting the rate of interest, even to zero, would not help. People, banks and firms could become so risk averse that they preferred the liquidity of cash to offering credit or using the credit that is on offer. In such circumstances, the economy would be trapped in recession, despite the best efforts of monetary policy makers. The graph below shows a liquidity trap. Increases or decreases in the supply of money at an interest rate of X do not affect interest rates, as all wealth-holders believe interest rates have reached the floor.

All increases in money supply are simply taken up in idle balances. Since interest rates do not alter, the level of expenditure in the economy is not affected. Consequently, monetary policy under these circumstances is futile.

Keynes saw the 1930’s as a time when aggregate demand needed boosting – C+I+G+(X-M) – as the economy was in underemployment equilibrium. With the help of the multiplier, output and employment would increase – GDP. But with increased saving leading to reduced consumption and a fall in aggregate demand, a recession will worsen.

The fact that income must always move to the level where the flows of saving and investment are equal leads to one of the most important paradoxes in economics – the paradox of thrift. Keynes explains how, under certain circumstances, an attempt to increase savings may lead to a fall in total savings. Any attempt to save more which is not matched by an equal willingness to invest more will create a deficiency in demand – leakages (savings) will exceed injections (investment) and income will fall to a new equilibrium. In the graph below, the point of equilibrium is at E where the saving curve SS and investment curve II intersect each other. The level of income at equilibrium is OY and saving and Investment are equal at OH. When the aggregate saving increases, the saving curve shifts upwards from SS to S1S1. The new equilibrium point is E1 with OY1 level of income. Saving and investment are equal at point OT. As the level of saving increases, national income decreased from OY to OY1. Similarly, the volume of saving and investment also declined from OH to OT.

The relevance of the paradox of thrift today is different from that during the Great Depression in the 1930’s. Back then consumers weren’t in as much debt as they are today and the government played a much smaller role in the economy with little or no welfare state to provide automatic stabilizers. Also the financial system wasn’t an interconnected as it is today and the financial engineering that evolved in the 2000’s allowed for the creation of instruments that had no real value to the economy – CDO and CDS. But after the GFC the expectations of consumers became very negative and as workers became fearful of losing their jobs what followed was an increase in savings as they wanted less exposure to debt, which negatively affected consumption.